Case Study: Optimal RRSP/TFSA Contributions for John and Mary Smith

To understand the interplay between these six factors, lets look at an example.

John

Mary

Income

$100,000

$60,000

Marginal tax bracket

43%

33%

RRSP contribution room

$ 50,000

$ 50,000

TFSA contribution room

$ 25,500

$ 25,500

Existing RRSPs

$100,000

$100,000

Note also:

John and Mary have $15,000 cash on hand.

Neither has opened a TFSA yet.

Based on their retirement plan, they need to invest $23,000 per year to have the retirement they want.

They plan to retire in 25 years and have worked out a specific retirement lifestyle, for which they will need 56,000 per year each (in today’s dollars). That means they will probably be in the 33% tax bracket in retirement (at today’s tax rates).

Neither of them has a pension.

Their tax refund is normally $1,500, excluding the RRSP portion of their refund.

They have a line of credit with an available limit of $30,000.

Let’s look at each factor individually and then figure out the optimal RRSP/TFSA contribution:

1. Needed to have the retirement you want – They need to contribute a total of $23,000 between them to their RRSPs and/or TFSAs.

2. Optimal RRSP contribution based on tax bracket – John can contribute up to $19,000 in the 43% tax bracket and Mary can contribute up to $17,000 in the 33% tax bracket. Contributions above these amounts will receive small tax refunds.

3. RRSP or TFSA? – Based on their retirement plan, we expect they will retire in the 33% tax bracket. John should contribute the first $19,000 to his RRSP because he is now in the higher 43% tax bracket. After that, he will be in the 33% tax bracket, which is the same as in retirement. Mary is in the 33% tax bracket both now and in retirement, so the benefits of RRSP and TFSA are about even for her. When the benefits are about even, we usually give a slight edge to the TFSA because of flexibility, unless the tax refund is specifically needed for something.

4. Optimal based on lifetime contribution room – John has $50,000 of room and gains $18,000 additional room each year. That is a total of $500,000 over 25 years. To maximize it, he would need to contribute $20,000 per year.

Mary has $50,000 of room and gains $10,800 additional room each year. That is a total of $320,000 over 25 years. To maximize it, she would need to contribute $12,800 per year.

Maximizing is a very good idea for John. He will have a 10% tax gain by receiving refunds of 43% of his contributions, but will only have to pay 33% tax when he withdraws from his RRSP after retiring. Maximizing RRSP contributions is less critical for Mary.

Both have $25,500 of TFSA contribution room and gain $5,500 additional room each year. That is a total of $137,500 over 25 years. To maximize it, they would each need to contribute $6,520 per year to their TFSAs.

5. Needed to get the refund you want – They have no specific use for their tax refund.

6. Cash or borrowed funds available – They have $15,000 in cash. Contributing $19,000 to John’s RRSP would give us a tax refund of about $9,500, including their other tax deductions and credits. If Mary’s contribution is to an RRSP, then the tax refund will be about $11,000. They also have $1,000 per month available cash flow after all expenses, which could be used to make payments on an RRSP loan or for next year’s RRSP contribution.

Putting together their optimal strategy

For John and Mary, let’s start with their retirement goal. They need to invest $23,000 per year to have the retirement they want. That is the key target figure.

Adjusting for their tax brackets, contributing to RRSP for John is the most beneficial for the first $19,000. We can contribute the remaining $4,000 for Mary, since they will be in the same 33% tax bracket after John’s $19,000 RRSP contribution.

RRSP or TFSA? This additional $4,000 for Mary could be either to her RRSP or TFSA, since she is in the 33% tax bracket and we also expect they will retire in the 33% tax bracket. We will lean towards the TFSA, since it is more flexible.

Adjusting for John’s lifetime contribution room, John needs to contribute $20,000 per year to maximize his lifetime room. John’s optimal contribution based on his tax bracket is only $19,000, which will not quite maximize his lifetime contribution room. Any additional contribution would be in the lower 33% tax bracket. Since this difference is small, it is best to only contribute $19,000 and keep the additional $1,000 room in case John’s income is higher in a future year.

Adjusting for their cash and borrowed funds available, they have $15,000 cash, so they are short $8,000 from being able to contribute their $23,000 goal. If they use the top-up strategy and contribute $15,000 from cash and $8,000 from their credit line, they will be able to pay off their credit line with their tax refund. Their tax refund will be $9,500 if Mary’s contribution is to a TFSA and $11,000 if it is to her RRSP. We can use $8,000 to pay off their credit line from the RRSP top-up and have either $1,500 or $3,000 cash left over.

For next year, the numbers will probably be similar and they should probably contribute another $23,000. If they start contributing their available $1,000 per month, they will have contributed $12,000 and be $11,000 short. This could come from their tax refund next year, if they do the top-up strategy again and all $23,000 next year is to their RRSPs.

Working out a plan like this can be very precise, but in reality we need to leave some room for error, so that their cash flow is not too tight. This looks like it will work for them, but leaves them with hardly any extra cash available. We would generally prefer the TFSA for Mary’s contribution, but we might use an RRSP just to get a bit more tax refund to give them a bit of a cash flow buffer now. They do have a $30,000 available credit line for emergency purposes, however.

Note that John’s $19,000 contribution should be $9,500 to John’s RRSP and $9,500 to Mary’s spousal RRSP in order to try to keep their retirement incomes about the same.

After weighing all these factors, the optimal contributions for John and Mary are probably:

This year

Future years

John’s RRSP

$ 9,500

$11,500

John’s contribution to Mary’s spousal RRSP

$9,500

$7,500

Mary’s RRSP

–

$4,000

TFSA contribution (for either)

4,000

–

Total contributions

$23,000

$23,000

I hope this example gives you a sense of how to integrate the 6 key factors to determine your optimal strategy.

About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.

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About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

I have trouble making the decision without knowing their debt situation. I would assume that they have a mortgage. Would it not be prudent to give the early repayment of the mortgage equal weight the RRSP and TFSA – after the RRSP tax savings are achieved?

Avoiding years of mortgage interest payments could be as lucrative an investment as a TFSA mutual fund.

If the RRSP and TFSA are approximately equal, another reason not to go with the RRSP is that the “refund” is too easily spent, forgetting that there is a corresponding tax liability on withdrawal. When someone contributes to their TFSA they have paid all their dues up-front and there is nothing to overlook. Few account for their RRSP properly by discounting its value by the amount of tax they expect to pay on it.

Both RRSPs and TFSAs are said to be tax free on interest earned. However, with RRSPs, you are taxed on your income when you withdraw. But part of that income will actually be interest. How does one (or the CRA) differentiate the interest money vs the contributed money? Is it a simple proration such as
$$$ contributed in lifetime $500,000
Interest earned 50,000 (10%)
Total 550,000
Income at retirement 42,000
x actual contribution 90%
Taxable income 37,800

In most cases, I would disagree. Most people that focus on their mortgage end up with a far lower net worth after 20 years for 2 reasons:

– Mortgage rates are very low and a lot lower than expected returns on investments, especially equity investments. Today, we are getting mortgages at 2.59%. Equity mutual funds should average far more long term.
– Behaviour. Most people that pay off their mortgage end up spending much of that money and never make up for lower RRSP/TFSA contributions.

This article is all about working out the optimal amount to invest in RRSP or TFSA based on your retirement goal and all the important factors. Paying off your mortgage would be in addition to this. It is usually a good idea to pay off your mortgage before you retire, but in most cases, it is best to plan to pay it off only shortly before retirement and invest the rest of your money.

You are right that what you do with the refund is key. That is not an issue, however, if you use the net investment.

For example, if you invest $10,000 and are in a 40% tax bracket, you end up using $6,000 of cash to invest the $10,000. If you compare that to $6,000 in a TFSA, you end up in a similar situation in the future. After you withdraw the RRSP and pay tax, you would end up with exactly the same amount as you would with the TFSA (if you are still in a 40% tax bracket when you withdraw).

When you withdraw from your RRSP, you are taxed on the full amount of the withdrawal. The income inside the RRSP is all tax-free, whether interest, dividends or capital gains. 100% of the RRSP withdrawals are taxed as RRSP withdrawals, not investment income.

Are you thinking of a couple that lives together but never claims common law status?

If they did show their status as single, the net result would be essentially the same, except for the spousal RRSP contribution. The amounts to contribute and which type of account would probably be the same.

The spousal RRSP gives them a tax savings, so if they claim as single, they would not have that tax saving. Claiming as common law would probably cost them less tax.

I’m not understanding one of the basic assumptions “Based on their retirement plan, they need to invest $23,000 per year to have the retirement they want.” Invest it where? Investing $23,000 in the RRSP means that they will have to pay tax on that $23,000 when it comes out in retirement and also pay tax on anything that earned over the years while invested in the RRSP.If they invest the same $23,000 in the TFSA, they get both the original contribution and anything it earned all back out tax-free at retirement.

Does the study really mean they have to invest
[ $23,000 in a TFSA ]
OR
[$23,000 in an RRSP and invest all of the tax refund generated by that $23,000 contribution in ??? something else/a new RRSP contribution??? ]

I don’t understand how it can be a simple statement of $23,000 without stating where it has to be contributed. How can we know they will require an annual investment of $23,000 before we’ve picked where it will be invested?

You are right, of course. A financial plan can get quite complex. I simplified the assumption here to explain the main concepts in the plan. To include all the nuances can make the plan and the article much longer and more technical.